Chapter 14 Financial markets and expectations

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Corporate bonds

A bond issued by a corporation in order to raise financing for a variety of reasons such as to ongoing operations, M&A, or to expand business. The term is usually applied to longer-term debt instruments, with maturity of at least one year.

Government bonds

A bond issued by a national government, generally with a promise to pay periodic interest payments called coupon payments and to repay the face value on the maturity date. The aim of a government bondis to support government spending

Discount bonds

A bond that is issued for less than its par—or face—value. Discount bonds may also be a bond currently trading for less than its face value in the secondary market

Indexed bonds

A bond which has its coupon payments adjusted for inflation by linking the payments to some inflation indicator, such as the Consumer Price Index (CPI) or Retail Price Index (RPI). ... These bonds are also less volatile than nominal bonds and help investors maintain their purchasing power

Current yield

A bond's annual return based on its annual coupon payments and current price (as opposed to its original price or face). The formula for current yield is a bond's annual coupons divided by its current price.

Treasury inflation protected securities

A form of U.S. Treasury bond designed to help investors protect against inflation. These bonds are indexed to inflation, have U.S. government backing, and pay investors a fixed interest rate as the bond's par value adjusts with the inflation rate.

Yield curve

A graphical representation of yieldson similar bonds across a variety of maturities. A normal yield curve slopes upward, reflecting the fact that short-term interest rates are usually lower than long-term rates. That is a result of increased risk premiums for long-term investments

Bond ratings

A letter grade assigned to bonds that indicates their credit quality. Private independent rating services such as Standard & Poor's, Moody's Investors Service, and Fitch Ratings Inc. evaluate a bond issuer's financial strength, or its ability to pay a bond's principal and interest, in a timely fashion.

Treasury notes

A marketable U.S. government debt security with a fixed interest rate and a maturity between one and 10 years. Treasury notes are available from the government with either a competitive or noncompetitive bid

Expected present discounted value

A sequence of future payments is the value today of this expected sequence of payments discount factor.The price of a stock depends on the expected future profits earned by the firm. The concept of a present discounted value (PDV), which is defined as the amount you should be willing to pay in the present for a stream of expected future payments, can be used to calculate appropriate prices for stocks and bonds

Treasury bills

A short-term U.S. government debt obligation backed by the Treasury Department with a maturity of one year or less. Treasury bills are usually sold in denominations of $1,000. However, some can reach a maximum denomination of $5 million in non-competitive bids.

Discount factor

A weighting term that multiplies future happiness, income, and losses in order to determine the factor by which money is to be multiplied to get the net present value of a good or service.

Maturity

Bond: the length of time over which the bond promises to make payments to the holder of the bond. Refers to the final payment date of a loan or other financial instrument, at which point the principal (and all remaining interest) is due to be paid. The term fixed maturity is applicable to any form of financial instrument under which the loan is due to be repaid on a fixed date.

Life of a bond

Bonds often are referred to as being short-, medium- or long-term. Generally, a bond that matures in one to three years is referred to as a short-term bond. Medium or intermediate-term bonds generally are those that mature in four to 10 years, and long-term bonds are those with maturities greater than 10 years

Junk bonds

Corporate bonds that are high-risk and high-return. They have been rated as not investment grade by Standard & Poor's or Moody's because the company that issues them is not fiscally sound. These bonds tend to have the highest return, compared to other bonds, to compensate for the additional risk.

Present discounted value

Defined as the amount you should be willing to pay in the present for a stream of expected future payments, can be used to calculate appropriate prices for stocks and bonds

Face value

Describes the nominal or dollar value of a security, as stated by its issuer. For stocks, the face value is the original cost of the stock, as listed on the certificate. For bonds, it is the amount paid to the holder at maturity, which is customarily $1,000.

Ex dividend price

Ex-dividend date: The first day a stock trades without its dividend included in the share price. Investors who buy shares before the ex-dividend date are entitled to the upcoming dividend payment, while those who acquired shares on or after this date are not

External finance

External sources of finance include Financial Institutions, Loan from banks, Preference Shares, Debenture, Public Deposits, Lease financing, Commercial paper, Trade Credit, Factoring, et

Internal finance

Finance that does not come from issuing stocks or bonds but rather from the company's retained earnings and/or depreciation. One may think of internal finance as a company's savings account that it may use to buy assets when it needs.

Coupon bonds

Is a debt obligation with coupons attached that represent semiannual interest payments. With coupon bonds, there are no records of the purchaser kept by the issuer; the purchaser's name is also not printed on any kind of certificate.

Risk premium

Is the return in excess of the risk-free rate of return an investment is expected to yield; an asset's risk premium is a form of compensation for investors who tolerate the extra risk, compared to that of a risk-free asset, in a given investment.

Yield

It is a financial ratio that indicates how much a company pays in dividend/interest to investors, each year, relative to the security price. Yield is a measure of cash flow that an investor is getting on the money invested in a security.

Rational speculative bubbles

Show that price bubbles can arise in models in which the current market price depends on expected future price changes. Under rational expectations, such models tend not to yield a unique expression of agents' expectations.

Arbitrage

Simultaneous purchase and sale of an asset to profit from an imbalance in the price. It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in different forms.

Long term interest rate

Yields on bonds with a longer maturity.Refers to government bonds maturing in ten years. Rates Are mainly determined by the price charged by the lender, the risk from the borrower and the fall in the capital value. Long-term interest rates are generally averages of daily rates, measured as a percentage.

Short term interest rate

Yields on bonds with a short maturity.Rates at which short-term borrowings are effected between financial institutions or the rate at which short-term government paper is issued or traded in the market. Short-term interest rates are generally averages of daily rates, measured as a percentage.

Yield to maturity

The discount rate at which the sum of all future cash flows from the bond (coupons and principal) is equal to the current price of the bond. The YTM is often given in terms of Annual Percentage Rate (A.P.R.), but more often market convention is followed.

Dividends

The distribution of reward from a portion of the company's earnings and is paid to a class of its shareholders. ... Dividends can be issued as cash payments, as shares of stock, or other property, though cash dividends are the most common

Fads

Mean-reverting deviations from intrinsic value caused by social or psychological forces similar to those that cause fashions in political philosophies or consumerization.

Equity finance

Process of raising capital through the sale of shares. Companies raise money because they might have a short-term need to pay bills or they might have a long-term goal and require funds to invest in their growth.

Equity premium

Refers to the excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of equity investing. ... As a rule, high-risk investments are compensated with a higher premium

Discount rate

Refers to the interest rate charged to the commercial banks and other financial institutions for the loans they take from the Federal Reserve Bank through the discount window loan process, and second, the discount rate refers to the interest rate used in discounted cash flow

Expectations hypothesis

States that the current price of an asset is equal to the sum of expected discounted future dividends conditional on the information known now.

Stocks or shares

Stock is a general term used to describe the ownership certificates of any company, and shares refers to the ownership certificates of a particular company. So, if investors say they own stocks, they are generally referring to their overall ownership in one or more companies.

Random walk

Suggests that changes in stock prices have the same distribution and are independent of each other. Therefore, it assumes the past movement or trend of a stock price or market cannot be used to predict its future movement.

Coupon payments

The annual interest payment that the bondholder receives from the bond's issue date until it matures. Coupons are normally described in terms of the coupon rate, which is calculated by adding the sum of coupons paid per year and dividing it by the bond's face value.

Term premium

The compensation that investors require for bearing the risk that short-term Treasury yields do not evolve as they expected. Studying the term premium over a long time period allows us to investigate what has historically driven changes in Treasury yields.

Present value

The current value of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows.

Term structure of interest rates

The relationship between maturity and yield. When graphed, the term structure of interest rates is known as a yield curve, and it plays a central role in an economy.

Debt finance

When a company borrows money to be paid back at a future date with interest. It could be in the form of a secured as well as an unsecured loan. A firm takes up a loan to either finance a working capital or an acquisition.

Coupon rate

The yield paid by a fixed-income security; a fixed-income security's coupon rate is simply just the annual coupon payments paid by the issuer relative to the bond's face or par value. The coupon rate, or coupon payment, is the yield the bond paid on its issue date.